Tonchia S. Industrial Project Management Planning Design and Construction
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In this section, we see how Cost Estimating in Project Management requires a
different approach from that used in Cost Accounting procedures, typical of opera-
tions management, procedures based on the allocation of costs – classified as direct
or indirect – to cost centres. The innovative approach of Cost Estimating in Project
Management follows certain trends that are already present in advanced Cost
Accounting, which in turn are based on Activity-Based Costing (ABC) techniques.
The difficulty of accurately and reliably calculating the full cost of a product/
project/work contract lies in the problems of allocating indirect costs, which by
definition cannot be immediately ascribed to a certain product/project/work con-
tract. Figure 10.2 illustrates the traditional passages from costs (classified as fixed/
variable and direct/indirect) to the cost centres (allocation) and the products
(attribution).
ABC was created in response to the traditional technique used for calculating the
full cost of a product (or project or work contract) and based on the division of
indirect cost on a single base or multiple bases (bases, i.e. criteria, such as direct
labour, cost of materials, number of machine-hours per product, etc.). When – like
in today’s world – variable costs decrease (in particular the percentage of labour),
while indirect costs (i.e. those relative to technology, design, trade, etc.) increase
(such as, for example, the depreciation costs of highly automated plants), allocating
10.2 Cost Estimating and Project Budget Calculation 123
COST
CENTRES
AUXILIARY
CENTRES
COMMON
CENTRES
PROJECT
FULL COST
costs
directed
to:
indirect
costs
variable
costs
fixed
costs
products
products
centres
centres
Fig. 10.2 Traditional allocation of indirect costs through cost centres
124 10 Project Cost Management
indirect costs on the grounds of direct variable costs (particularly on the traditional
amount of direct man-hours or standard times) can cause consistent distortions in
the calculation of the full cost.
Back in 1985, Miller and Vollmann claimed in their famous paper published in
the Harvard Business Review that indirect costs are independent of production vol-
umes but depend instead on various types of transactions:
– Logistical (such as those relative to customer orders)
– Balancing (namely, all those activities linked to the availability in space and time
of the materials, labour and machinery needed to meet the demand)
– Quality (e.g. the quality control procedures)
– Change (as a consequence of starting new projects or modifying pre-existing ones)
Cooper and Kaplan (1991) believe on the other hand that indirect costs are driven
by complexity, whereas direct costs are mainly variable and are therefore driven by
volumes; they distinguish between four types of cost-generating activities, each of
which has different drivers:
– Manufacturing activities (direct labour, materials and power required, the driver
being the production volume)
– Activities for running the production plants (such as maintenance)
– Production-supporting activities (such as machine tooling)
– Product-supporting activities (such as product development)
Except for manufacturing activities, in all the other cases there can be a variety of
drivers: the number of customer orders, manufacturing orders and supplier orders, the
number of lots, of items (common or special) and levels listed in the bill of materials,
the amount of handling, tooling, the number of defects, complaints, etc.
ABC is an innovative technique aimed at calculating the full cost of a product
(or project or work contract) starting from the cost of the resources used. Assigning
the cost of the resources to the single products does not occur through cost centres,
as tradition dictates (Fig. 10.2), but occurs via the activities (Fig. 10.3): in other
words, it is the activities that exploit the resources, whereas products do not use up
resources, but activities.
There are therefore two stages:
●
During the first, the cost of the resources is assigned to the activities (by means
of first-stage drivers, also known as cost drivers or resource drivers).
●
During the second, the activities are linked to the products or projects (by means
of second-stage drivers or activity drivers).
Cost Estimating in Project Management adopts the ABC approach to calculate
the full cost of a project, but in this case the technique is used to estimate the costs
of a project or a work order, and not of a product.
The starting point is represented by the activities needed to accomplish the
project, which are described in the WBS.
The second step is to link each activity (also called task) to the resources needed,
which are organised and described in the POBS (which in turn is connected to the
Organizational Breakdown Structure or OBS).
This link is established by criteria that in practice coincide with the resource
drivers found in ABC: for example, the allocation of the resources for the entire
duration of the activity, either in proportion to its duration or as work hours
required.
This allocation must be compatible with the calendars and the levels of satura-
tion of the resources, which can be exploited by more than one project.
When estimating the cost of human resources, it is necessary to include both the
cost of calling or exploiting the persons for a certain activity (independently of the
time required) and their cost per hour.
Finally, using criteria similar to the activity drivers of ABC (e.g. the duration of
a certain activity in a project), it is possible on one hand to calculate the overall cost
of the project so as verify if there are adequate funds (according to the company’s
overall budget breakdown structure – BBS) and, if necessary, revise the activities
of the WBS, and, on the other, create and develop the PBBS of the project.
10.3 Cost Budgeting: Budget Breakdown Structure,
Baseline, Cost Accounts
As described in the previous section, Cost Estimating allows the total budget for a
given project to be defined. This budget is part of the overall budget of the com-
pany destined to projects (such as those for product development, work orders,
COST OF
RESOURCE 1
COST OF
RESOURCE 2
COST OF
RESOURCE 3
COST OF
ACTIVITY 1
COST OF
ACTIVITY 2
COST OF
ACTIVITY 3
FULL COST OF
PROJECT A
FULL COST OF
PROJECT B
First
stage
Second
stage
Resource
drivers
Activity
drivers
Fig. 10.3 Calculation of full product cost according to Activity-Based Costing (ABC)
10.3 Cost Budgeting: Budget Breakdown Structure, Baseline, Cost Accounts 125
126 10 Project Cost Management
improvement plans, etc.). The portion set apart for projects can coincide with the
entire budget, in the case of ETO companies or in general, those working to order.
The budget of a project can be considered as a management tool: it is expressed
in monetary terms and refers to a project that must be carried out (whereas in
management control, it is considered a future accounting period). The budget
takes into account all the necessary resources, unfolds in time according to a certain
baseline (with interim checks, in the case of management control) and is articu-
lated into cost accounts (while in management control, there is a profit and loss
statement, the assets and liabilities sheet and estimates of the cash flow during the
year). In both cases, the issues of leadership, confrontation, coordination and
motivation are the same.
The budget of a project is structured according to the PBBS mentioned previ-
ously (Fig. 10.4). In the case of work orders, the expected margin of profit (return)
must be detracted from the available amount (which can be the value of the contract
or the starting price of a bid): the remaining amount is the base budget; this can
include target costs and estimated costs: the former are those negotiated (e.g. x
million euro per kilometre of motorway), whereas the others are not, and can only
be predicted, a task that always hides a certain margin of risk (e.g. the cost of setting
up a plant, before its turnkey delivery to the buyer).
OVERALL
BUDGET
(B.B.S.)
PROJECT-A
BUDGET
(P.B.B.S.-A)
PROJECT-B
BUDGET
(P.B.B.S.-B)
“BASE-
LINE”
MNGT
RESERVE
BASE BUDGET
TARGET
COSTS
(negotiated)
ESTIMATED
COSTS
(not negot.)
COST
ACCOUNTS
UNDISTRI-
BUTED
BUDGET
MEASURED
EFFORT
APPORTIONED
EFFORT
LEVEL OF
EFFORT
...
...
Fig. 10.4 Project Budget Breakdown Structure (PBBS)
The base budget is subdivided into two parts: the main one is the baseline,
whereas a smaller amount is set aside for contingencies (management reserve).
Management reserve is particularly important in the case of work orders, when the
contract includes penalty clauses for late deliveries; considering the inevitable
randomness of some variables, a certain budget percentage is necessary to reduce
the risk of project delays.
The baseline on the other hand is the available sum that can be used to carry out
the activities relative to the project. It is so called because its evolution in time can
be depicted as a line. It usually has an S shape, since during the first stages expendi-
ture is low, and then rises sharply, to finally decrease in the last stages of the project
(Figs. 10.6 and 10.7). Therefore, in a cost/time Cartesian representation, the base-
line curve starts at the origin of the axis to reach a final point, which indicates both
the duration of the project and its overall cost (commonly known as budget), which
corresponds to the maximum value of the baseline.
This sum includes the so-called Cost Accounts (CA) that are relative to the Work
Packages (WP) carried out by well-established resources. The integration between
costs and work schedule is termed as “Cost/Schedule Control System Criteria – C/S
CSC” (or also “C.Spec.”) by the Department of Defense – DoD – or “533 System”
by the National Aeronautics and Space Administration – NASA.
In other words, the CA are defined by combining the POBS with the WBS (who
does what, respectively): the tasks described in the WBS are aggregated into work
packages; organizational managers are responsible for these WP, and they have a
certain CA at their disposal to pay for the necessary resources. Figure 10.5 could
also include a third dimension, rising up from the page, which structures the
elementary units of the CA, to rebuild the PPBS.
Therefore, the project manager delegates technical and managerial responsibility for
the various chunks of the WBS (i.e. the activities) to WP manager, who is also respon-
sible for the CA. The project manager retains a part of the baseline for the direct, overall
management of the project: this portion is known as undistributed budget (Fig. 10.4).
The criteria used to define each CA must be based on the efforts needed to
deliver the activities of the project; these efforts can be classified as follows:
– Measured Effort (ME) – an effort that can be divided into work packages (WP)
Consisting of activities (30-40 at the most) of limited duration, and whose out-
puts (deliverables) can be measured directly
– Apportioned Effort (AE) – an effort that by itself is not readily divisible into
short-span work packages but that is directly proportional to the ME, and there-
fore to the WP (these are indirect activities, but the effort they require is linked
to the amount of direct work expressed by the WP)
– Level of Effort (LE) – an effort of a general or supportive nature, which is not
proportional to the ME and cannot be ascribed to the WP (fixed activities, inde-
pendent of the size of the WP)
Hence, in order to carry out the operations described in the WP, it is necessary
to have a CA that takes into account the ME, AE and LE; work packages deliver
partial outputs known as deliverables, that document/concretise the work carried
10.3 Cost Budgeting: Budget Breakdown Structure, Baseline, Cost Accounts 127
128 10 Project Cost Management
out, enable assessments to be made (checking whether the technical–qualitative
goals have been achieved, and the times and costs conform to those established) and
trigger the subsequent activities depicted in the network diagram of the project.
As shown in Fig. 10.6, all decisions concerning or affecting costs – in other
words, the commissioned costs – are made a long time before paying the actual
amounts: the decisions are made when defining the concept of the product and
planning the project, therefore before the activities start. These first stages are cru-
cial, and must be carefully managed, not only because of the technical repercus-
sions on the product but also to determine its costs. The fact that it must be
calculated so long beforehand is what makes cost management in a project so diffi-
cult. The curve of costs incurred in accomplishing work coincides with the planned
baseline which in turn – if the prediction is correct – will also coincide with the
ACWP (see following section).
It must be underlined that cost-related decisions made during the planning stage
not only serve to estimate the cost of the project and therefore the necessary budget,
but will also have a profound impact on the overall costs, once production has
started. Planning plays a crucial role, even from an economic viewpoint; although
it accounts for only 5% of the cost of the product, it can often be responsible for
over 75% of the overall manufacturing costs.
PROJECT
Project
Manager
Mana
-ger
Mana
-ger
Mana
-ger
Mana
-ger
W.B.S.
P.O.B.S.
CA
CA
CA
CA
WP WP WP WP
Fig. 10.5 The origin of Cost Accounts
time
$
PROJECT DURATION
PROJECT BUDGET
E
X
P
E
N
D
I
-
T
U
R
E
end of
project
start of
project
COMMISSIONED COSTS
Fig. 10.6 Decisions affecting costs, and payment moments
10.4 Cost Control and Variance Analysis 129
10.4 Cost Control and Variance Analysis
As mentioned in the previous section, the baseline curve illustrates how the pre-
dicted costs relative to a project unfold throughout the duration of the project. Since
it considers both costs and times before they actually occur, the baseline is also
known as Budgeted Costs of Work Scheduled (BCWS).
Once the project has started, it is necessary to control its progress, not only in
terms of work and technical performances, but also in terms of its cost, so as to
intervene in time if the events require it. Cost control is carried out using, as well
as the baseline, two other curves with acronyms similar to that used to indicate
the baseline:
●
The Actual Costs of Work Performed (ACWP) curve, namely that describing the
work actually performed and its actual costs
●
The Budgeted Costs of Work Performed (BCWP) curve, in other words, the curve
describing the actual work performed but at the budgeted costs
The ACWP curve, considering both the actual costs and times, is an ex-post
curve and is therefore the opposite of the baseline (or BCWS), which is ex ante.
However, the ACWP and BCWS curves alone are insufficient for analysing the
budget variances for projects in progress. A third curve is necessary – BCWP – which
is a hybrid of the previous two, considering the actual work performed but at the
budgeted costs. A lower expenditure than that budgeted can reveal delays in the work
in progress.
The need for the three curves to analyse budget variance when controlling
progress is clearly shown in Fig. 10.7: at any given time (monitoring date), the
future trend of the ACWP is unknown; moreover, a simple comparison between
130 10 Project Cost Management
Fig. 10.7
Curves used to monitor project costs with respect to the budget
BCWP
ACWP
CV
COST
VARIANCE
D
SV
SCHEDULE
VARIANCE
BCWS
C
B
ACWP
BCWS
BCWP
= Actual Costs of Work Performed
= BASELINE = Budgeted Costs of Work Scheduled
= Budgeted Costs of Work Performed
costs
time
today
delay
final
schedule
variance
final
cost
variance
BUDGET
AT COMPLETION
EARNED
AT COMPLETION
A
ACWP and the baseline would be insufficient, since it is possible that by that date,
the exact budgeted amount could have been spent (so ACWP and baseline would
have the same value on the y-axis), but less work could have been carried out, at
higher costs. Thus the need for the BCWP, since this curve shows how much should
have been spent at the budgeted costs for the work that was actually carried out: if,
for instance, on a given day the BCWP is below the baseline, it is clear that less
work was done than that scheduled, since both curves refer to the budgeted costs.
Figure 10.7 shows a typical example of cost variance and a contemporary delay:
the ACWP curve is above the baseline (BCWS) and the BCWP is below it. On the
monitoring day, the difference on the y-axis between the value of ACWP and
BCWP is the cost variance (CV), while the difference between baseline and BCWP
indicates the schedule variance (SV), expressed in terms of costs. It would be a
mistake to consider the CV as the sole difference between ACWP and baseline,
since they would only coincide if the work progressed in perfect time. The SV gives
an estimate of the cost variances during the progress of the project; the amount that
has not yet been spent is simply due to the fact that certain expenses have not
occurred because the respective activities have not yet started.
It is therefore possible to calculate the percentage of cost and time variances at
a given time t during the progress of the work, using the following formulas:
%() ()/ ()CV CV BCWStt t=
%() ()/ ()SV SV BCWStt t=
Only at the end of the project will it be possible to calculate cost and time variances
in a different manner, measuring the differences of the final values of the ACWP
curve and the baseline both on the y-axis (costs) and the x-axis (time).
The existence of the third curve, namely the BCWP, also gives the name to the
method just described: Earned Value Method, defined as the value of the actual
work according to the budget. Given the total value of the project, or Budget at
Completion (BAC), and the percentage of work progress at a given time t (%L), the
Earned Value (EV) can be calculated as shown here:
EV BAC() %tL=∗
When controlling a project and comparing budgeted and actual costs, it is neces-
sary to take into account the efficient use of the various resources.
With reference to Fig. 10.8, for every resource used to complete a work order,
it is possible to calculate its predicted cost by multiplying the unitary cost or price
of the resource (on the y-axis) by its use rate (on the x-axis), for example, in the
case of designers:
(€ per hour)
*
(hours per order) = € for designing each work order
The total area of actual and final costs is equal to the algebraic sum of the three
areas – budgeted cost, variances in the price of the resources (top part of the
BUDGETED (STANDARD)
COST
EFFICIENCY
VARIATION
PRICE VARIATION
Resource
unitary
cost
Resource units
in the work
ACTUAL
COST
worsening
increase
Fig. 10.8 Variance Analysis between budgeted and actual costs due to variations in the price of
the resources and in efficiency
10.4 Cost Control and Variance Analysis 131
132 10 Project Cost Management
Fig. 10.8) and changes in operational efficiency (which decreases when moving
towards the right hand side of the Fig. 10.8 and improves when moving to the
left, because in this latter case less resource units are used for the job). It must
be noted that the area corresponding to variances in the price of the resource
takes into account both the budgeted costs and the increase (or decrease) in
operational efficiency.
10.5 Capital Budgeting: Analysis and Evaluation
of an Investment Project
Cost management and its three stages described previously (Estimating,
Budgeting and Control) are still insufficient to give a full view of the monetary
situation: as well as an economic analysis, it is necessary to perform a financial
analysis of the project, so as to take into account the time variable. A project is
in fact a form of investment. The capital required for its delivery, and the
expected gains, should therefore be allocated and considered throughout time
(Capital Budgeting).
An investment, of any type, can be defined as a sequence of net monetary flows,
structured so that at the beginning expenditures (costs) prevail, and only afterwards,
the takings (gains or revenues).
Figure 10.9 shows two typical investment profiles relative to the launch of a new
product, one of which is a pioneer (appearing for the first time on the market) and
the other a follower (appearing later).
These curves are extrapolated from cost and gain histograms relative to discrete
periods, so the S-shaped curve of the baseline is the integral (i.e. the area bounded
above by the graph of the function and below, by the x-axis) of this extrapolation
curve: the value of the baseline on a given date is therefore equal to the sum of pre-
dicted costs incurred up to that day, and depicted as upright bars (histograms) of
below-zero value (costs).
The moment of maximum slope for the baseline coincides with the bar having
the greatest absolute value of cost, which occurs somewhere around the middle of
the project’s life cycle.
When taking into account the financial aspects of a project, it is necessary to
define the monetary value throughout time as a cost (periodic percentage) sustained
to anticipate a taking (e.g. the cash flow deriving from a loan received) or to delay
an expenditure (e.g. when asking for a postponement of payment); in other words,
profits are made by accepting to postpone an income or accelerate an expenditure.
The transport of money throughout time requires correction factors: capitalising
factor if moving from present to future, actualisation one if the other way round.
As described in greater detail in any financial text, it is sufficient to multiply the
amount to be moved as follows:
(
)()11++
−
i and i
nn